How Do Different Types Of Risk Influence A Portfolio?

Essentially, in investment types of risk can be described as the
uncertainty of future returns. Since share and stock prices move up and
down, potentially changing all day every day, this uncertainty can be
very real. The movement of prices, known as volatility, is caused by one
or both of two factors. These are:

Market risk and Investment specific risk

Market risk
cannot be avoided and has an effect on an entire investment market. It
is also known as Systematic Risk. In recent years, this type of risk
seems to hit most if not all major stock exchange indices at the same
time. In this connected world, very little appears to be safe.

Some
things are likely to cause this market risk. For example, there may be
significant changes in a national economy. This may and often does take
the form of changes to interest rates, inflation or unemployment
predictions, GDP growth and so on. Other factors might include changes
to taxation rules made by a government.

Obviously, the private
investor can only avoid such perils by remaining out of each and every
market! In the modern world, with pension funds and mortgage repayment
vehicles it is virtually impossible to avoid all stock market risk (information here).

It
could be said that broadly, all companies have a similar exposure to
systematic risk. However, there are obvious exceptions. For example, the
very largest companies in a market - the biggest 15 or so in the FTSE
100, for example - will move on political, economic, environmental and
general news issues. In contrast, a company that is the 400th largest on
the FTSE is going to move on such news very rarely.

Thus, it
could be argued that the very largest firms also have some form of
country risk associated with them. This is probably not a bad thing
though in many market conditions. After all, when there is non-specific
good news, their share price may well benefit!

Systemic risk is something that was largely theoretical in
markets until the banking collapse of 2008 (information here). It has been widely
ackowledged that the world's financial system is now more interconnected
than ever before and that a failure in one place can have dramatic
impacts on other unexpected locations. The banking system is the prime
example.

This
academic paper
discusses it's role in financial markets. This type of risk and it's
unexpected consequences has prompted the European Union to form the
European Systemic Risk Board
to investigate and suggest measures to limit the potential impact and problems that it can cause.

Investment specific risk
relates to a company or industry. It is also known as Unsystematic
Risk. The factors which cause this are generally not connected to
political or national economic factors. Examples of factors which might
include Investment specific risk are:

- New competitors entering a market,

- Technological improvements which render existing products or business processes obsolete, or

- Changes to the credit rating (and therefore borrowing costs) of a company

These
are types of risk that can be reduced or limited by holding a
diversified portfolio. This is possible because different companies will
be impacted by the same changes in different ways.

An investor
may hold positions in companies that will deliberately move in opposing
directions at news of the same events to lower the risk and price
volatility in a portfolio. However, should all assets move in broadly
the same direction at the same time, this offsetting would not work.

The
classic example used to explain this would be to hold shares in an
ice-cream company and an umbrella company. If it rains, umbrellas are in
demand. If it sunny, ice-cream sells. Clearly this is a very simplistic
approach, but it does offer a glimpse into the thinking.

Simply relative

It is worth pointing out that this is ultimately all relative to you and I - the individual owner of the assets. Our individual investment risk tolerance will have a large impact on how we manage a portfolio. For example, some people are frightened of inflation risk and seeing their capital devalued while others are happy to take a chance and accept capital risk.

These can be tricky concepts to understand and get right, but they are worth the effort. Asset allocation (information here) can be a very useful tool in reducing portfolio risk and sometimes boosting annual returns. It is worth pointing out that there is nothing inherently wrong in shunning funds in search of alpha (information here) and focusing on strategies to simply bring in the market beta return (information here).